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Harmful rule changes ahead for Education Savings Accounts?

One irritating thing about taxes — and anything related to taxes — is that the rules change with annoying frequency.

Case in point: several changes are likely to be forthcoming at year's end for tax-favored Coverdell Education Savings Accounts (ESAs). Certain provisions enacted by a Republican-led Congress in 2001 are set to expire, and at this point the current Congress doesn't seem inclined to renew them.

Although Coverdells have been overshadowed by state-sponsored "529" plans, they actually offer more investment flexibility than 529s, giving parents greater choice in where their money is invested. In addition, ESAs (unlike 529s) can be used not only for college expenses, but also to help pay qualified education expenses at the elementary, middle school, and high school levels. That's a great benefit for parents with children in private schools, as well as for parents paying for academic tutoring or extended-day programs.

Unfortunately, the "pre-college" aspect of ESAs seems likely to be on the way out. Moreover, contribution ceilings for Coverdell accounts, already not very high, could be sharply reduced.

Details from the Wall Street Journal:

[F]amilies planning to use a Coverdell account to pay for pre-college education expenses should think twice about opening or contributing to an account this year. Starting next year, withdrawals from Coverdells to pay expenses from kindergarten through 12th grade will no longer be tax-free, unless Congress acts to extend that benefit, which is not a sure thing.

Another prospective rule change would lower the limit on annual contributions to $500 starting next year, making Coverdells less useful for college savings. Already, the $2,000 limit has made Coverdells much less popular than 529 college-savings plans, which offer similar tax benefits for college costs and [have no federally imposed contribution limit]....

[Right now, i]nvestors can claim a Hope or Lifetime Learning tax credit for education in the same year they use Coverdell funds, as long as the tax credit and Coverdell money aren't used for the same expense. For example, an investor can take a tax credit for tuition in the same year he is using Coverdell money for books.... This is another benefit that could expire at year's end; the two tax benefits could become mutually exclusive.

The WSJ reports that Sen. Charles Grassley (R-Iowa) has introduced legislation that to preserve the pre-college benefit of Coverdell ESAs and keep the annual contribution cap from falling. But Joe Hurley, founder of SavingForCollege.com, is skeptical that Sen. Grassley's legislation will see the light of day — in part because many lawmakers don't like the idea of Coverdell accounts being used to pay for private school at the elementary and secondary level.

Mr. Hurley suggests either spending Coverdell accounts on K-12 expenses before the end of the year, or just accepting that the funds will have to go to college expenses later. He also points out that investors can move funds in Coverdell accounts to 529 accounts without triggering tax penalties.

That might make sense if the rules expire that currently allow people to use Coverdell funds and claim Hope or Lifetime Learning credits in the same year. Investors in 529 accounts have that same right, and [right now at least] it isn't at risk of changing.

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